Common errors when accounting for investment property (IAS 40) – Part 1

Following on from our recent ‘common error’ series on property, plant and equipment, we continue this month with common errors when accounting for investment property.

Ordinarily, investment property would meet the definition of ‘property, plant and equipment’ (PPE) and be accounted for in accordance with IAS 16 Property, Plant and Equipment, with revaluations recognised in other comprehensive income (OCI). However, a specific standard, IAS 40 Investment Property, was developed to account for this specific type of asset and requires fair value increments and decrements to be recognised in profit or loss instead.  

Investment property is often a significant balance in the statement of financial position of property investors. Making one or a number of common errors in relation to this standard could therefore have a material impact on profit or loss.

There are numerous ways in which preparers can get the classification of investment properties wrong. This month we focus on the first six common errors and will discuss the remainder next month.  

Error 1 – Investment properties are not PPE

Investment properties usually comprise a building or piece of land rented to tenants over a long period (more than one year). As such, they would meet the definition of PPE to be accounted for under IAS 16 if the separate standard on investment property did not exist.

Property, plant and equipment are tangible items that:

  1. are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and
  2. are expected to be used during more than one period.

Definition of ‘property, plant and equipment’ in IAS 16


Investment property
is property (land or a building—or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:

  1. use in the production or supply of goods or services or for administrative purposes; or
  2. sale in the ordinary course of business.

Definition of ‘investment property’ in IAS 40

A common error is to account for investment properties as PPE under IAS 16 rather than as investment properties using the more specific standard, IAS 40. This could have a material impact on the financial statements, with fair value movements incorrectly recognised in OCI instead of profit or loss.

Error 1

Incorrectly accounting for investment properties as PPE, and recognising fair value movements in OCI instead of in profit or loss.

Error 2 – Investment properties must be land or buildings

In Error 1 above, we noted that the definition of PPE includes tangible items held for ‘rental to others’ and that investment property is ‘land or a building – or a part of a building – or both’.

The deliberate inclusion of the words ‘held for rental to others’ in the definition of PPE indicates the intention that some assets held for rental are not investment property. This includes ‘owner occupied property’, which is defined in IAS 40, but which is accounted for under IAS 16.

Investment property is property (land or a building—or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:

  1. use in the production or supply of goods or services or for administrative purposes; or
  2. sale in the ordinary course of business.

Owner-occupied property is property held (by the owner or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes.

Definitions from IAS 40, paragraph 5

Classifying assets as PPE or investment property is relatively simple in some situations, such as for a car hire vehicle which is clearly not land or buildings and cannot fall within the scope of IAS 40.

However, it is more complicated for some types of land and buildings that earn rental, such as telecommunication towers, where it is not clear whether those assets are land or buildings.

The issue of whether a telecommunications tower is a ‘building or a part of a building’ was considered by the IFRS Interpretations Committee who took a narrow view of the meaning of ‘building’ and concluded that a telecommunications tower, while leasing space to telecommunication operators, lacks features usually associated with a building such as walls, floors and a roof. Similarly, structures such as advertising billboards and gas storage tanks would also not be considered investment property.

Error 2

Treating assets held for rental as investment property when they are not land or buildings.

Error 3 – Property being constructed or developed for future use as investment property

Property companies often purchase properties with a view to renovating or redeveloping them in order to maximise rental returns in future, rather than for sale. Prior to 2009, such properties were scoped out of IAS 40, and instead accounted for under IAS 16 as PPE. Any fair value increments during long periods of construction were effectively ‘locked’ in OCI because IAS 16 prohibits recycling of asset revaluation reserves to profit or loss when PPE is derecognised.

Amendments to IAS 40 in 2009 specifically require these properties to be accounted for as investment properties, even during the construction or development phase.

The following are examples of investment property:
  1. land held for long-term capital appreciation rather than for short-term sale in the ordinary course of business.
  2. land held for a currently undetermined future use. (If an entity has not determined that it will use the land as owner-occupied property or for short-term sale in the ordinary course of business, the land is regarded as held for capital appreciation.)
  3. a building owned by the entity (or held by the entity under a finance lease) and leased out under one or more operating leases.
  4. a building that is vacant but is held to be leased out under one or more operating leases.
  5. property that is being constructed or developed for future use as investment property.

IAS 40, paragraph 8

Even though this amendment was made a number of years ago, some preparers may not be aware of it. Where the fair value/revaluation model is being applied, this could result in a material misstatement of profit or loss during the course of construction.

Error 3

Accounting for property held for construction or development for future use as investment property as PPE.

Error 4 – Land is investment property if you haven’t decided what you want to do with it

Property companies often purchase blocks of land, either to sell as subdivided parcels of land, or for development as apartments, homes or offices. Such properties are classified as ‘inventories’ under IAS 2 Inventories because the entity will sell them in the ordinary course of business.

Sometimes property companies may acquire a parcel of land without knowing exactly what they intend to do with it. Possibilities include:

  • Developing and then selling in the ordinary course of business as inventory (IAS 2)
  • Use as owner-occupied land (IAS 16), or
  • Renting out and holding for capital appreciation (IAS 40).

The following are examples of investment property:

  1. land held for long-term capital appreciation rather than for short-term sale in the ordinary course of business.
  2. land held for a currently undetermined future use. (If an entity has not determined that it will use the land as owner-occupied property or for short-term sale in the ordinary course of business, the land is regarded as held for capital appreciation.)
  3. a building owned by the entity (or held by the entity under a finance lease) and leased out under one or more operating leases.
  4. a building that is vacant but is held to be leased out under one or more operating leases.
  5. property that is being constructed or developed for future use as investment property.

IAS 40, paragraph 8

A common error seen in practice is property companies assuming that all land acquired is inventory, measured at the lower of cost and net realisable value. This could result in assets on the balance sheet and profit or loss being understated if such property would otherwise have been recognised at fair value.

Error 4

Treating land with an undetermined future use as inventories rather than investment property.

Error 5 – Temporarily leased properties are not always investment properties

Despite the definition of ‘investment property’ specifically including property held to earn rentals, if the intention from the outset is to sell a property in the ordinary course of business, the fact that it is being rented out while the property is being marketed does not automatically mean that it is an investment property.

Large properties may take a long period of time to sell, and renting them out in the short-term is merely a means of reducing cash outflows from rates and taxes, etc. Also, tenanted commercial properties may achieve a higher selling price than untenanted properties. These types of properties should be classified as inventories.

If the entity measures investment property at fair value, automatically classifying such properties as investment property rather than inventories could result in profit on sale of the property being recognised prematurely in profit or loss.

Example:

Property Co purchases a vacant plot of land in the CBD for $10 million which it intends to sell in the normal course of business.

Property Co has had expressions of interest from the owners of several buildings on adjacent lots but is aware that the sale process could take a significant amount of time.

Property Co therefore decides to lease the land to Parking Co which will use the land to operate a temporary parking lot until the land is sold.

Property Co’s accounting policy is to measure investment property at fair value.

At reporting date, Property Co had an independent valuation of the land, which is now worth $11 million.

Because Property Co’s intention is to sell the land in the ordinary course of business, the land should be accounted for as inventories and measured at cost (i.e. $10 million).

If it incorrectly classifies this land as investment property because of the existence of the lease to Parking Co, Property Co will overstate profit and assets by $1 million in the current year when the fair value increment is recognised under IAS 40, and understate profits in future periods when the property is eventually sold.

Error 5

Assuming that leased properties held for sale in the ordinary course of business are always investment properties.

Error 6 – Vacant properties with no leases ARE sometimes investment properties

At the opposite end of the spectrum to Error 5 above, a property company may acquire a vacant block of land or property (commercial property or residential units) with a view to renting these out under one or more operating leases.

The following are examples of investment property:
  1. land held for long-term capital appreciation rather than for short-term sale in the ordinary course of business.
  2. land held for a currently undetermined future use. (If an entity has not determined that it will use the land as owner-occupied property or for short-term sale in the ordinary course of business, the land is regarded as held for capital appreciation.)
  3. a building owned by the entity (or held by the entity under a finance lease) and leased out under one or more operating leases.
  4. a building that is vacant but is held to be leased out under one or more operating leases.
  5. property that is being constructed or developed for future use as investment property.

IAS 40, paragraph 8

Even though the property is not rented at acquisition, or may become vacant at a later date, the property is still classified as an investment property because, according to the definition of ‘investment property’ in IAS 40, it is ‘held ... to earn rentals …’.

Getting the classification of such properties wrong will be of consequence if the entity measures investment properties at fair value. It would be incorrect to classify this type of property as:

  • Inventories - because it is not being held for sale in the ordinary course of business, and
  • PPE - because the intention is not to use this as owner-occupied property.

Error 6

Assuming all vacant properties are NOT investment properties.